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Estimating asset correlations from stock prices or default rates: which method is superior?

Author

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  • Düllmann, Klaus
  • Kunisch, Michael
  • Küll, Jonathan

Abstract

This paper sets out to help explain why estimates of asset correlations based on equity prices tend to be considerably higher than estimates based on default rates. Resolving this empirical puzzle is highly important because, firstly, asset correlations are a key driver of credit risk and, secondly, both data sources are widely used to calibrate risk models of financial institutions. By means of a simulation study, we explore the hypothesis that differences in the correlation estimates are due to a substantial downward bias characteristic of estimates based on default rates. Our results suggest that correlation estimates from equity returns are more efficient than those from default rates. This finding still holds if the model is misspecified such that asset correlations follow a Vasicek process which affects foremost the estimates from equity returns. The results lend support for the hypothesis that the downward bias of default-rate based estimates is an important although not the only factor to explain the differences in correlation estimates. Furthermore, our results help to quantify the estimation error of asset correlations dependent on the risk characteristics of the underlying data base.

Suggested Citation

  • Düllmann, Klaus & Kunisch, Michael & Küll, Jonathan, 2008. "Estimating asset correlations from stock prices or default rates: which method is superior?," Discussion Paper Series 2: Banking and Financial Studies 2008,04, Deutsche Bundesbank.
  • Handle: RePEc:zbw:bubdp2:7314
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    References listed on IDEAS

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    4. Bollerslev, Tim & Engle, Robert F & Wooldridge, Jeffrey M, 1988. "A Capital Asset Pricing Model with Time-Varying Covariances," Journal of Political Economy, University of Chicago Press, vol. 96(1), pages 116-131, February.
    5. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    6. Lopez, Jose A., 2004. "The empirical relationship between average asset correlation, firm probability of default, and asset size," Journal of Financial Intermediation, Elsevier, vol. 13(2), pages 265-283, April.
    7. Rösch, Daniel, 2003. "Correlations and Business Cycles of Credit Risk: Evidence from Bankruptcies in Germany," University of Regensburg Working Papers in Business, Economics and Management Information Systems 380, University of Regensburg, Department of Economics.
    8. Düllmann, Klaus & Scheicher, Martin & Schmieder, Christian, 2007. "Asset correlations and credit portfolio risk: an empirical analysis," Discussion Paper Series 2: Banking and Financial Studies 2007,13, Deutsche Bundesbank.
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    Cited by:

    1. Christoph Wunderer, 2017. "Asset correlation estimation for inhomogeneous exposure pools," Papers 1701.02028, arXiv.org.

    More about this item

    Keywords

    Asset correlation; single risk factor model; small sample properties; structural model; Basel II;

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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